High-yield debt is looking vulnerable after strong outperformance in the first half

Alexandra Scaggs

For the US corporate bond market, current conditions can be described with a comparison made famous in the financial crisis film Margin Call: the proverbial game of musical chairs is still on but the pace of the song has become more frenetic. This year, the corporate bond market has been defined by a marked shift away from quality with lower-rated issues outperforming bonds from companies with stronger balance sheets. This has been driven by expectations that the economy will continue to expand. But with the US Federal Reserve now raising rates, investors who ploughed into lower quality credit are now clearly vulnerable to the turn in the market cycle.Investment grade companies rated at triple B minus and higher lost 3.1 per cent this year through to the end of June, according to ICE BofAML indices, while those rated in the junk tier (double B plus and below) have eked out a positive return of 0.1 per cent.The divergence is even starker in the lowest triple C-rated tier of debt that makes up just 12 per cent of the high-yield market’s value. Triple C plus, triple C and triple C minus bonds have outperformed the rest of the market by a wide margin in the first half, posting a total return of 3.9 per cent, according to ICE BofAML indices. Some of the outperformance is due to simple supply and demand. Investors had anticipated a much sharper drop-off in the supply of investment grade bonds in the first half of this year than the 5 per cent drop estimated by Bloomberg. Demand from foreign investors was also 13 per cent lower than last year as hedging costs increased with rises in US short-term interest rates and the dollar, according to estimates from strategists at Bank of America Merrill Lynch.But the shift also reflected reduced perceptions of risk. The gauge of market risk implied by the spread between the yields on those securities and government debt has narrowed by 135 basis points, according to CreditSights. The question for the second half of the year for high-yield debt is trade and the economy. Many of the US’s junk-rated companies are plays on global growth, which could be hamstrung by a trade war if one comes to pass. More broadly, the question is how high the Fed can raise rates before companies struggle to service their cost of debt and whether companies in the triple B segment will be downgraded to junk after piling on leverage in deals.When that happens, higher quality and less leveraged companies will probably benefit — but at that point, equity markets and other risky securities might start to struggle as well, which would hurt investors’ ability to earn returns.

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Sun Tzu

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